The world of retirement planning can sometimes feel complex and intimidating, but understanding the fundamentals of different types of retirement plans is crucial for financial planning. Two prominent types of retirement plans are the Defined Benefit Plan and the Defined Contribution Plan. While they may seem similar on the surface, there are significant differences between the two concerning what is defined and certain.

The Defined Difference: Benefit vs. Contribution

A Defined Benefit Plan is one where your employer guarantees a fixed monthly payment for your lifetime upon retirement. The promised benefit is thus "defined." Contrarily, a Defined Contribution Plan's certainty lies in the specific contributions made into the employee's account, meaning the contributions are "defined."

A further distinction lies in account setup: a Defined Contribution Plan establishes individual accounts for each employee, while a Defined Benefit Plan maintains a communal account for all employees.

Calculation Methods: How Contributions and Benefits Are Determined

The calculation method for contributions and benefits is another primary differentiator between these plans. A Defined Benefit Plan uses a formula based on an employee's salary and tenure. This formula determines the future pension payments due to the employee upon retirement. The employer's contribution to fulfill this future obligation is assessed according to stringent funding guidelines, employing conservative future value estimations and considering any surplus in the account.

On the other hand, a Defined Contribution Plan may incorporate a match or profit-sharing component. This feature bases the employer's contribution on the employee's current salary deferrals or the business's profit margin.

Risk and Investment Responsibility: Who Bears the Burden?

The risk and responsibility for investment performance diverge significantly in these two plans. For a Defined Contribution Plan, once the contributions are made, the future value is uncertain. It is the employee's responsibility to select from various investment types and reallocate funds, typically on a quarterly basis. The performance of these investments ultimately determines the value of the plan upon retirement.

Conversely, in a Defined Benefit Plan, the investment risk lies squarely with the employer. Should there be gains beyond their obligations, employers can reallocate them. The risk is removed from the recipient, making the benefit independent of investment performance.

Retirement Outcome: Defined Benefits or Undefined Future?

As the names suggest, a Defined Benefit Plan offers fixed, defined benefits, while a Defined Contribution Plan allows you to determine your contributions with benefits that are not guaranteed. Therefore, the amount you save in a Defined Contribution Plan will depend on the collective contributions of you and your employer throughout your employment and the performance of your investments.

The choice between a Defined Benefit Plan and a Defined Contribution Plan largely depends on your risk tolerance, the level of control you wish to have over your investments, and your retirement income expectations. In a Defined Benefit Plan, you are promised a set monthly income upon retirement, while in a Defined Contribution Plan, your retirement income depends on how well your selected investments perform. Understanding these differences is key to making informed decisions about your retirement planning.

Summary

Defined Benefit plans and Defined Contribution plans can sometimes look similar, but the main difference is what is certain and defined. In a Defined Benefit Plan, your employer guarantees you a certain fixed monthly payment for the rest of your life, so the benefit is said to be defined. A Defined Contribution Plan’s only certainty is the amount that went into the employee account, so the contributions are defined.

Another definition is simply that a Defined Contribution plan has accounts for each employee, while a Defined Benefit plan has one account for all employees.

A Defined Benefit plan will use a formula based on an employee’s salary and years employed to determine the pension payments that are owed to the employee when he or she retires, and the employer’s contribution to pay for that future obligation is calculated based on strict funding guidelines using the guarantees present in the pension fund investment, a conservative future value estimation of any instruments exposed to the market, and any surplus present in the account at the time.

A Defined Contribution plan will sometimes have a match or profit-sharing component which uses the current salary deferrals of the employee or the current profit margin of the business to determine the employer contribution.

Once the contributions go in to a Defined Contribution plan, the future value is anyone’s guess, and the performance of the investments is the responsibility of the employee, who has the ability to pick and choose between at least a few types of investments and to reallocate quarterly.

The investment risk for a Defined Benefit plan is on the shoulders of the employer, but that could also mean that employers get to re-purpose any gains above their obligations as fiduciaries. The amount you save is going to depend on the amount of money you and your employer contribute collectively during your employment (and the performance of your investments).

With a Defined Benefit Plan, the risk rides on the shoulders of the employer and has nothing to do with the recipient. As the names of both plans imply, in a Defined Benefit Plan, your benefits are defined, while in a Defined Contribution Plan, you determine your contributions, and the benefits are not guaranteed.

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